Tue 12 May 2020

The Rule Against Reflective Loss

The Supreme Court is currently considering an appeal in the case of Sevilleja v Marex Financial Limited which relates to the proper application and scope of the rule against reflective loss. 

The rule relates primarily to the right of a shareholder to sue for loss in circumstances where the shareholder does not have a loss which is separate and distinct from the loss caused to the company in which they are a shareholder. The rule has always been very strict in its application. In Prudential Assurance v Newman Industries [1982] Ch 204 the Court of Appeal in England & Wales refused to allow an action to proceed by a shareholder even where the company was unwilling to instigate action itself. In that case, the court reminded us of the importance of respecting corporate structures as set out in the well-known case of Foss v Harbottle.

Since the Prudential case, however, there have been various cases in the UK and the commonwealth relating to the rule, which are far from consistent with each other (Johnson v Gore Wood & Co (No 1) [2002] 2 AC 1 HL; Gould v Vaggelas (1985) 157 CLR 215; and Christensen v Scott [1996] 1 NZLR 273). In the Johnson case, Lord Bingham sets out three general propositions (paraphrasing): (1) Where a company suffers loss caused by a breach of duty owed to it, only the company may sue in respect of that loss. No action lies at the suit of a shareholder suing in that capacity and no other to make good a diminution in the value of the shareholder's shareholding where that merely reflects the loss suffered by the company; (2) Where a company suffers loss but has no cause of action to sue to recover that loss, the shareholder in the company may sue in respect of it; (3) Where a company suffers loss caused by a breach of duty to it, and a shareholder suffers a loss separate and distinct from that suffered by the company caused by a breach of duty owed independently to the shareholder, each may sue to recover the loss caused to it by the breach of each respective duty.

In the same case Lord Millett clearly explains that in the case of the first of Lord Bingham's propositions the shareholder cannot recover his loss because if they were allowed to do so, then either there would be a double recovery at the expense of the defendant or the shareholder would recover at the expense of the company and its creditors. Neither course of action is, therefore, permitted by law. This is a matter of principle and there is no discretion involved. In other words, the action lies with the company and that satisfies the interests of justice because, if the company makes a recovery, then all shareholders benefit from the recovery rather than just the one shareholder who decided to sue. So the proper application of the principle ensures, as Lord Bingham went on to say, "that a party does not recover compensation for a loss which another party has suffered" while also ensuring that "the party who has in fact suffered loss is not arbitrarily denied fair compensation".

In Gardner v Parker [2005] BCC 46 Neuberger LJ held that the rule applies regardless of whether the shareholder's cause of action is the same as the company's because the rule is directed at barring certain types of loss rather than causes of action. He also held that it is irrelevant whether or not the shareholder sues in his capacity as shareholder opining that "...it is hard to see any logical or commercial reason why the rule against reflective loss should apply to a claim brought by a creditor or employee who happens to be a shareholder, of the company, if it does not equally apply to an otherwise identical claim by another creditor or employee, who is not a shareholder in the company…I can see no basis whatever in logic or principle as to why, if a claim qua employee is barred by the rule, a claim made qua creditor is not similarly so barred. In most cases where an employee's claim is barred by the rule against reflective loss, the employee will be a creditor of the company. It is hard to see why a creditor who is an employee should be treated differently from any other creditor of the company when it comes to applying the rule against reflective loss". So whether you are a shareholder-creditor or a non-shareholder creditor, the rule against reflective loss applies.

Or does it? The Court of Appeal in Giles v Rhind [2003] 2 WLR 237 dealt with the situation where the defendant's wrongdoing prevented the company from enforcing its claim. The defendant in this case was a director of one company, left and set up a rival business and then stole his former company's business using trade secrets. The former company was left without funds to pursue a claim and was put into administration whereupon the guilty director made an application for security for costs which the administrators could not put up. So the company had to discontinue proceedings. The claimant (who was a fellow director and shareholder of the company now in administration) raised his own proceedings against his former colleague for breach of a shareholders agreement. The trial judge held that Johnson applied and struck out the claim. The Court of Appeal distinguished Johnson on the issue of causation, holding that the position is different where the company is disabled from pursuing a claim by the conduct of the wrongdoer and allowed the claim to proceed. So, Giles is an exception to the general rule.

Or is it? Giles has only been relied upon successfully once in the case of Perry v Day [2004] EWHC 3372 (Ch) and Lord Millett, sitting as a judge in the Hong Kong case of Waddington Ltd v Chan Chun Hoo [2009] 4 HKC 381 has been rather scathing of the decision and has held that the exception outlined in it does not exist. Even cases which have cited Giles with approval have noted that the exception recognised by it is "very limited" (Kazakhstan Kagazy plc v Arip [2014] 1 CLC 451). Effectively, the exception can only be argued where the wrongdoer has made it "impossible" for the shareholder to pursue their claim. In Scotland, Lord Glennie has considered the rule and the exception in Giles in the case of McLeod v Rooney 2010 SLT 499. Lord Glennie does not decide whether Giles is an exception to the rule but rather holds that the "importance of [Giles] is that it shows that the court must take account of the reality of the situation. In a case where the company is disabled from pursuing the claim against the wrongdoer the risk of double recovery is no longer a factor; and if that disability was caused by the action of the wrongdoer, then the problem of causation is readily overcome".

This brings us neatly to Sevilleja. The question for the Supreme Court is one which is undecided - does the rule against reflective loss apply to claims by creditors who are not shareholders of the relevant company? (albeit that Neuberger LJ makes obiter remarks in Gardner on that question). Mr Sevilleja had two companies which were used by him for foreign exchange trading. They were clients of Marex. Marex succeeded in a claim against the companies for $5million. However, when a freezing injunction was served on the companies it only caught $4,000 because, in the interim, Mr Sevilleja had stripped the companies of their assets including $9million held in bank accounts, which he had transferred to bank accounts in his name. The action taken against him was for the torts of inducing the companies to violate Marex's rights and intentionally causing Marex loss by unlawful means. Mr Sevilleja defends the action on liability but also claims that the action is barred by the rule against reflective loss. The Court of Appeal agreed with him. It held that "If a creditor were able to pursue a claim in relation to the asset stripping of the company such as in the present case, that would bypass and subvert the pari passu principle, applicable to the unsecured creditors of the company in the event of liquidation, that the assets of the company be distributed rateably". Recovery by one creditor would prejudice others. The exception in Giles was approved by the court but said not to apply as Marex cannot establish that the wrongdoing has made it "impossible" for the companies to pursue a claim against him. There is nothing to suggest that a liquidator appointed by the creditors would be unable to do so nor is there anything to prevent Marex from taking an assignation of the companies' claim.

So there matters lie and we await the Supreme Court's judgment with interest. Marex argue, contrary to the views of Neuberger LJ in Gardner that the reflective loss rule should not apply to a shareholder creditor when the claim is raised in the capacity of creditor and it should also not apply to claims raised by someone as a pure creditor. It is a procedural rule founded on the shareholder's position as per Foss v Harbottle and goes no further than that. The limits of the rule will be difficult to establish because, as a matter of principle, the rule is surely either restricted to shareholders as Marex contend or is applicable wherever there is a risk of double-recovery as suggested in Gardner in which case there is no obvious reason to exclude creditors, employees or anyone else from the scope of the rule. The other interesting point will, of course, be the exception. If there is an exception then the restricted scope of it in Giles is likely to be where matters lie. The more difficult question is whether there should be any exception at all or whether, as Lord Millett suggests, the rule against reflective loss is absolute.

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